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By definition a hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. The primary goal of a hedge isn’t to make money, rather to protect from losses and limit risk.
Within the Futures industry, hedging is based on the principle that cash market prices and futures market prices tend to move up and down together. This movement is not necessarily identical, but it usually is close enough that it is possible to lessen the risk of a loss in the cash market by taking an opposite position in the futures market. Taking opposite positions allows losses in one market to be offset by gains in the other. In this manner, the hedger is able to establish a price level for a cash market transaction that may not actually take place for several months.
Hedging with futures is a valuable risk management tool if used at the right time. Hedging allows you to lock in a certain price level and protects you against adverse price moves. In other words, you are committed to a specific buying or selling price and are willing to give up any additional market benefit if prices move in your favor because you want price protection.
In conclusion, hedging involves holding opposite positions in the cash and futures markets. So, as the value of one position rises, the value of the other position falls. If the value of the hedger’s cash market position increases, the value of the hedger’s futures market position decreases. Hedging protects the hedger from unfavorable price changes. Although a futures hedger is unable to benefit from favorable price changes, you are protected from unfavorable market moves.
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